The global aviation industry offers an optimistic outlook for the rest of 2014 as an expanding economy and rising cargo and passenger traffic drive demand. Rise in passenger travel demand, particularly in North America, Middle East and Asia Pacific, plus accelerated replacement of obsolete aircraft will likely boost the industry’s overall performance.

According to the International Air Transport Association (IATA), the expansion of the economic cycle along with rapid GDP and world trade growth is expected to boost air travel by 5.9% − the best since 2011. The rise in capacity may, in turn, lead to a 3.5% cut in airfares, thus benefiting travelers.

The IATA remains cautiously positive on the industry and projects overall airline profits of $18.0 billion on revenues of $746 billion for 2014, from an estimated 3.32 billion passengers. In 2014, net profit margin is expected at 2.4%, up from 1.5% in 2013. The industry is expected to generate $5.42 from every departing passenger on an average, a rather soft number for a high-risk business.

Additionally, air cargo volumes -- an important indicator of business confidence -- have been in a troubled spot since 2010. However, figures have been recovering since the start of 2014 and could expand 3.1% in the course of the year to reach $197 billion.

Nonetheless, the bullish stance may be partially impeded by the negative vibes surrounding air travel following the recent Malaysia Airlines catastrophe and an upturn in jet fuel prices. Apart from geo-political tensions in Eastern Europe and the Middle East, an alarming increase in the number of airborne plane crashes raises safety concerns.

Regional Forecast

North America: With the world’s largest economy improving, airlines in North America hold bright prospects in 2014. Consolidation benefits, rising travel demands and several new and enhanced ancillary revenues provide an impetus to growth. Although performance will continue to vary substantially between different U.S. carriers, a strong 2013 has made way for a higher 2014 profit forecast of $9.2 billion.

Asia-Pacific: Carriers in this region are expected to post profits of $3.2 billion in 2014, higher than $2.0 billion recorded in 2013, based on strong cargo demand and healthy passenger travel demand.

Europe: Europe, which continues to recover slowly within the home front, will tend to be affected by stiff competition and high regulatory costs. Thus, despite having the second best load factor, the IATA expects this year’s post-tax profit for European carriers to reach $2.8 billion.

Middle East: Per the IATA, profits from carriers in the Middle East are expected to grow from $1.0 billion in 2013 to $1.6 billion in 2014 driven by rapid growth of airlines in the Gulf. Regional co-operation and international partnerships should further add to the success of these carriers.

Latin America: The region’s profitability is expected to enhance substantially from $200 million in 2013 to $1.1 billion in 2014. Weaker performance in the home market is expected to be offset by success in some long-haul markets and consolidation benefits.

Africa: Airlines in the African continent could see their profits touching the $100 million mark, rebounding from a loss of $100 million in 2013. Although performance is improving slowly, Africa remains the weakest region, owing to low developmental opportunity for inter-Africa connectivity, high infrastructure cost and taxation.

Emergence of Middle East Carriers

As U.S. passenger carriers are still trying to recover from the domestic economic sluggishness, several Gulf-based airlines have come to the forefront, fortifying their positions within the global airline industry. Emirates leads the pack, followed by Etihad and Qatar Airways, expanding in Europe, Africa and the BRICS, thus laying the foundation for an overall successful aviation sector.

Recently, Emirates stood true to its commitment made last year by announcing a $56 billion order to buy 150 777x jets from The Boeing Co. (BA), with an optional plan to buy 50 additional aircraft. Emergence of these cash-rich airline companies remains a concern for the legacy carriers, including those in the U.S., which might lose a chunk of their international market as most passengers continue to move through the Gulf.

India – A Golden Opportunity

The aircraft manufacturing giant Airbus and Boeing have both raised their 20-year outlook on India, owing to the high appetite for growth but low market penetration of airline services in the country. Further, India's large demography supports the growth of air transportation service as the country's working population continues to rise. The optimism swelled after Boeing received orders for 42 B-737 aircraft from SpiceJet worth $4.4 billion, while Tata Group’s twin airline joint ventures with Singapore Airlines and Air Asia Berhad have opted for Airbus' A-320 fleet. Brazilian vendor Embraer SA (ERJ) also got a $2.5 billion order from Indian regional airline Air Costa.

According to Boeing, Indian carriers will buy 1,600 aircraft worth $205 billion between 2013 and 2032, while its counterpart Airbus expects India to place orders for 1,290 planes valued at $190 billion. The aircraft manufacturing duo has predicted that a significant part of the order will constitute single-isled narrow bodied aircraft like Airbus A320 or Boeing 737s. The country recently got its latest passenger carrier in the form of Air Asia India, which aims to reduce costs and eventually transfer them into growth.

The long-term rosy picture is, however, partially offset by the short-term weakness within India's aviation industry, which continues to suffer from over capacity. Additionally, airfares have also surged in the last five years resulting in lower demand for air service.

Underlying Factors for 2014 Profits

In the base-case scenario, there are several dynamics that will act as driving factors for overall airline profits in 2014. These include:

Passenger & Cargo: The IATA suggests that economic recovery coupled with faster GDP and world trade growth will drive air transportation demand. Customers on the other hand will benefit from cheaper air travel as one-way fares are expected to reduce 3.5% this year. The association projects global airline passenger growth of 5.9%. The average industry load factor is expected at 80.4%.

Coming to demand-supply balances, demand (measured in traffic) is expected to outpace capacity in 2014. While the projected capacity increase is 5.5%, air travel demand is expected to see a 5.9% pickup.

Fuel Price Effect: Airline profit outlook depends largely on fuel prices, the major variable component in the industry. For 2014, average jet fuel prices are expected to stay at $124.2 per barrel, a notch lower than the $124.5 per barrel cost in 2013. Lower jet fuel price drives airline profits by reducing operating expenses. However, the political crisis in Middle East has led to upward pressure on oil prices. The association projects fuel cost of $212 billion in 2014, accounting for almost 30% of the overall operating cost.

Fleet Restructuring: Air carriers at large are looking for fuel efficient fleets in order to reduce their cost burden that has increased 55% over the period 2006–2013. The carriers are concentrating more on making money rather than expanding its market share. The companies continue to replace old and depleted airplanes with new and upgraded ones. Escalating oil prices have also played a major part in the fleet replacement decision.

According to Boeing, over the next 20 years, global airlines are expected to invest around $5.2 trillion in fleet development. Over the long run, the carriers aim to replace their old narrow-body jets -- A320’s/B757-200/300 -- with advanced narrow-body airplanes such as A-321, A320 Neo and the B737 Max, for better service and demand-supply equilibrium.

Jet Renovation: With passengers demanding comfort and quality service along with proper security, airlines are focusing on aircraft redesigning with new and attractive products and services within the travel plan. United Continental Holdings Inc. (UAL) is offering premium flat-bed cabin seats on every long-haul international flight.

Further, the carrier has installed in-seat power on more than half of its mainline fliers and has paced up the installation of the satellite-based first ever Wi-Fi service for fliers. Delta Airlines Inc. (DAL) also plans to invest $750 million over the next two-year period to roll out Wi-Fi as well as renovate the interiors of its narrow-bodied aircraft over the next three years.

Hedging Strategies: Hedging strategies are frequently used by airline companies to cope with the rising fuel prices. The carriers use a combination of calls, swaps and collars at varying WTI crude-equivalent price levels to hedge.

Zacks Industry Rank

Within the Zacks Industry classification, airlines are broadly grouped into the Transportation sector (one of the 16 Zacks sectors).

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a point of reference, the outlook for industries in the top one-third of the list (with Zacks Industry Rank #88 and lower) is ‘Positive,’ the mid one-third of the list (between #89 and 176) is ‘Neutral,’ while the last one-third (#177 and above) is ‘Negative.’

The Zacks Industry Rank for the airline industry is currently #31, implying that the outlook remains positive on this sector for this year owing to a rise in passenger air travel demand.

Earnings Trends

The broader Transportation sector, of which aviation is a part, reflects a stable growth pattern. So far, 91% of the sector participants in the S&P 500 index that combined account for 97.7% of the sector’s total market capitalization have reported second quarter results, which have been fairly good in terms of growth rates and beat ratios.

Total earnings for these companies are up 11.7% on 6.7% higher revenues, with 90% of the companies beating EPS estimates and 80% coming ahead of revenue expectations. This is better performance than we have seen from the Transportation sector in other recent quarters.

The Consensus earnings expectation is pegged at 6.8% for the third quarter and 13.2% for 2014. The fourth quarter is expected to register earnings growth of 13.8%. The revenue growth expectation is pegged at 5.2% for the third and the fourth quarter, as well as for full-year 2014.

For more details about earnings for this sector and others, please read our ‘Earnings Trends’ Report.

OPPORTUNITIES

We believe industry consolidation and various ancillary revenues will boost the profitability and cost performance of most air carriers going forward. This is a suitable time for companies to consolidate for higher profits and operational efficiency.

Additional Revenue Gains: Air carriers are increasingly focusing on passenger satisfaction and experience to drive growth. JetBlue Airways Corp. (JBLU) augmented its TrueBlue loyalty program by allowing a single customer to earn and use points as a group, while Delta has upgraded its Economy Comfort seating in all transcontinental flights operating from New York’s JF Kennedy Airport to Los Angeles, San Francisco and Seattle. The IATA projects total revenue of $746 billion in 2014.

Mergers & Acquisitions: Airline companies unite in order to restore lost profits and broaden their perimeter. This was evident in the past mega mergers within the industry involving Northwest Airlines and Delta Air Lines in 2008, United Airlines and Continental Airlines in 2010 and AirTran Holdings and Southwest Airlines Co. (LUV) in 2011. All three companies -- Delta, United and Southwest -- are long-term beneficiaries on capacity and cost fronts.

The recently merged U.S. Airways Group Inc. and AMR Corporation have gained in size and capacity by creating the largest global carrier American Airlines Group Inc. (AAL). Despite the merged entity having more pricing power and control over a larger number of slots, we believe it will have little effect on the dynamics of the U.S. aviation industry as 80% of the same market will be dominated by the new American Airlines, United Airlines, Delta and Southwest Airlines.

Expansion: North American carriers are continuously striving to increase their range of domestic and international flights. United Airlines is planning an international service between Los Angeles and Melbourne from Oct 2014. To expand operations in Latin and Central America, United Airlines plans to introduce services to Chile, Dominican Republic and Belize from Dec 2014. Some U.S. carriers are also forming joint ventures with foreign partners to offer better connectivity to their customers.

Delta Airlines is strengthening its position in Seattle by adding several domestic and international destinations from the western coastal city in addition to reinstating its Barbados operation after a gap of 3 years. Likewise, after operating for several decades within the U.S. domestic market, Southwest Airlines is finally flying into international territory, with flights to the Caribbean. The carrier recently inaugurated services from Atlanta, Baltimore and Orlando to Oranjestad, Aruba and Montego Bay, Jamaica. Route expansion coupled with affordable ticket pricing will augment passenger travel demand.

New Choices: The formation of American Airlines has opened up new opportunities for Southwest Airlines, JetBlue and Virgin America as the merged entity has divested take-off and landing slots at Washington’s Reagan National Airport (DCA) and New York’s LaGuardia Airport (LGA). Further, American Airlines is currently in the process of divesting gates and related facilities at each of the Boston, Chicago, Dallas, Los Angeles and Miami airports.

Technology Upgrades: Air carriers are opting for numerous technology upgrades and system automation for various activities such as airline reservation, flight operations and website maintenance. These upgrades allow the companies to function effectively and efficiently, minimize expenses and render better customer service.

The latest is the installation of the Automated Passport Control (APC) kiosks, which will allow U.S. bound international passengers to enjoy a faster and smoother passport clearance process. Mobile boarding pass is another new technological advancement that allows passengers to use their smart mobile devices to get through security check points and board their flights sans any inconvenience or delay.

Emergence of Smaller Carriers

Although consolidation within the U.S. aviation industry will reduce competition, it is expected to be short lived because of the low barriers to entry within the same. Further, the rising profit margins within the industry have allowed the smaller operators to expand. The most aggressive of these are Spirit Airlines Inc. (SAVE), which plans to double its fleet size by 2017.

PeopleExpress is the latest addition in this list as the Virginia-based start-up plans to expand its services in 24 cities within the next 5 years. These ultra-low fare carriers are gaining popularity by providing low cost options for domestic travelers, thus gaining popularity among low end customers.

The major outperformers should be American Airlines, Delta and Southwest Airlines all with a Zacks Rank #1 (Strong Buy). We also uphold Zacks Rank #2 (Buy) stocks such as JetBlue Airways, Allegiant Travel Company (ALGT) and Alaska Airlines Group Inc. (ALK). Copa Holdings SA (CPL) and GOL Linhas A (GOL) currently hold a Zacks Rank #3 (Hold).

CHALLENGES

Of the many challenges facing the industry, the most crucial ones include slow economic recovery, volatile fuel prices, natural calamities, industry consolidation, government regulation, unionization, airport infrastructure constraints, technological investments and safety concerns.

Pitfalls of Industry Consolidation: Over the last few years, the U.S. aviation industry has seen several consolidations with the most significant one being U.S. Airways with American Airlines in 2013. With major and legacy airlines of the U.S. joining forces, the total number of carriers operating within the industry is becoming less. This has resulted in less competition, higher airfares and increased fees, thus affecting the fliers.

Pilot Shortage: Lack of qualified pilot is disrupting airline operation particularly for the smaller carriers in some parts of U.S. thus forcing them to keep their aircrafts grounded. The Federal Aviation Administration’s (FAA) rule of minimum 1,500 hour of flying experience is been held as the root cause for the shortfall of flight crew.

Oil Price Volatility: Fuel price volatility continues to be one of the significant challenges, as fuel costs are largely unpredictable. The geopolitical unrest will continue to affect crude oil prices. Airline carriers’ ability to pass along the increased costs of fuel to its fliers is restricted by the competitive nature of the industry.

Unionization: The airline business is labor intensive. Most of the employees are unionized and depend on various U.S. labor organizations. The relation between airlines and labor unions are governed by the Railway Labor Act, which states that a collective bargaining agreement between an airline and a labor union does not expire -- instead it becomes amendable as of a stated date. Failure to amend terms and conditions suitably may lead to work stoppages or strikes, and thereby hamper operations.

Similarly, the airline industry in the rest of the world is also exposed to labor related concerns -- proved by the ongoing pension-related dispute of Aer Lingus and its largest trade union, which led to the former reluctantly agreeing to pump in additional fund to revamp its superannuation scheme.

Federal Regulations: The airline industry is highly regulated, in particular by the federal government. All companies engaged in air transportation in the U.S. are subject to the regulations implemented by the Department of Transportation (DoT). Further, airlines are also regulated by FAA, a division of the DoT, primarily in areas of flight operations, maintenance and other safety and technical matters. The new stringent pilot duty and rest rules under FAR117 will increase the carriers’ expenses as the companies will need to hire more pilots to comply with the stated rules.

Technological Failure: Technological investment is a key expense for air carriers. The profitability of airlines could be affected by technology glitches or failure to invest in new technologies.

We expect Latam Airlines Group SA (LFL) and Bristow Group Inc. (BRS), to underperform the broader market. Both the stocks currently hold a Zack Rank #4 (Sell).
 



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Tickers in this Article: UAL, SAVE, LUV, LFL, JBLU, GOL, ERJ, DAL, CPA, BRS, BA, ALK, ALGT, AAL

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